The following post comes to us from Sudarshan Jayaraman of the Department of Accounting at Washington University in Saint Louis and Todd Milbourn, Professor of Finance at Washington University in Saint Louis.
In our paper, The Effect of Auditor Expertise on Executive Compensation, which was recently made publicly available on SSRN, we examine how auditor expertise influences the amount of equity-based compensation that firms grant to their executives. Our empirical tests are motivated by recent theoretical models that examine how the potential for financial statement manipulation influences managerial equity-based compensation. While more equity incentives may induce better strategic decisions and greater effort, they also encourage the manager to manipulate financial reports to artificially inflate the stock price, especially if the manipulation is unlikely to be detected. These theories predict that managers will be granted more equity-based compensation when financial misreporting is more likely to be detected, as the costs of granting such compensation are lower.
Following prior studies that find that greater auditor expertise reduces the incidence of earnings management and improves audit quality, we expect firms audited by an auditor with greater industry expertise to grant their executives more equity-based compensation. We find strong evidence in favor of our prediction. In particular, greater the expertise of the firm’s auditor, more is the amount of equity-based compensation that firms grant to their CEOs. This result is not only statistically robust, but also economically significant – a one standard deviation increase in auditor expertise increases CEO equity compensation by 1.4% relative to the mean. As most of our sample firms are audited by a Big Five (or Big Four) auditor, our tests effectively compare differences in equity-based managerial compensation between Big Five industry experts versus Big Five non-industry-experts.